EY: Worst is over for Cyprus, but downside risks remain

27 June, 2014

The near-term outlook for Cyprus remains grim as a result of last year’s near-meltdown of the financial sector and an aggressive austerity programme, but GDP is expected to contract by 4.3% this year, and for growth to resume only in 2016, according to the Summer 2014 EY Eurozone Forecast (EEF).

The survey said that the recovery in Cyprus is likely to be modest, given the considerable debt burden facing the private sector and the hangover from a severe credit crunch.
Moreover, Cyprus still faces considerable headwinds: household spending remains constrained by high unemployment, fiscal consolidation, declining wages and low (albeit improving) consumer confidence.
“We expect consumer spending to contract by 4.8% this year, before eventually returning to growth in 2016,” said the EY report. Solid progress has also been made on cleaning up the financial sector, the report added, explaining that “deposits have stabilised and the improving economic outlook encouraged the government to ease capital controls further and the Bank of Cyprus to release some of the EUR 933 mln of deposits frozen under the bailout last year. But challenges remain with the private sector, which is still highly leveraged and has non-performing loans weighing on bank balance sheets.” The EY report said that “the outlook for capital spending remains poor. Investment must contend with enormous pressure from fiscal consolidation, an impaired financial sector and poor business confidence. We expect investment to fall by around 8% this year, because of cuts to public capital expenditure and restricted access to credit.”
“Despite good progress on the policy front, the outlook remains uncertain and the risks high. Headline consumer price inflation has been falling since October 2013, underscoring the risk of a period of sustained deflation that would threaten the recovery.
“Although our baseline forecast is that Cyprus will avoid falling into a deflationary spiral, structural and transitory factors — including depressed demand, fiscal austerity, a strong euro and falling energy prices — present clear downside risks to our inflation projections. If deflation were to become entrenched, growth would be hit, particularly given the high levels of debt in the public and private sectors,” the EY report concluded.

Encouraging signs for Eurozone

In its report for the rest of the Eurozone, EY said that after two years of falling output, the Eurozone is forecast to grow by 1.1% this year, followed by expansion of 1.5% in 2015 and a slightly faster pace in 2016-18.
The Summer 2014 EY Eurozone Forecast added that exports are strengthening and a gradual pickup in domestic demand will drive a return to modest investment growth.
However, the threat of deflation persists. Inflation in the Eurozone was down to just 0.5% in May. Widespread deflation, or even a period of very low inflation, would add to the problems of sluggish growth by raising real levels of debt and by delaying spending and investment decisions.
“Part of the reason for weak price growth has been the strength of the euro in recent months. In response the European Central Bank’s (ECB) package of measures earlier this month will have some impact, and with the US now moving toward tighter policy, the euro should start to weaken later this year and in 2015. As such, EEF expects inflation to start to pick up, easing deflationary fears and supporting the wider recovery of investment and consumer spending.”
“Recent developments in the Eurozone underline that a gradual recovery is continuing, but that it remains divergent across member states. Countries that have done the most to improve competitiveness are reaping the rewards, but others are continuing to lag,” said Tom Rogers, Senior Economic Adviser to the EY Eurozone Forecast.
“And we remain concerned about the weakness of price growth and the risk that internal or external shocks might push the Eurozone toward a damaging deflationary spell. Recent moves by the ECB demonstrate it has the capacity to act, and we are encouraged by its intention to focus any quantitative easing program directly on the debt of non-financial firms.”
“We shouldn’t forget that the Eurozone is in a far stronger position than it was even 12 months ago, but economic recovery remains a muted affair. As on many other occasions throughout the last six years, it is still a case of two steps forward and one step back. Progress yes, but many challenges still exist,” added Mark Otty, EY Area Managing Partner for Europe, Middle East, India and Africa.